Relevant Cost Decisions
DECISION MAKING IN THE SHORT
TERM
Decisions
 A decision model is a formal method
of making a choice, often involving
both quantitative and qualitative
analyses
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Five-Step
Decision-Making Process
Step 1:
Obtain
Information
Step 2:
Make
Predictions
About
Future
Costs
Step 3:
Choose
An
Alternative
Step 4:
Implement
The
Decision
Step 5:
Evaluate
Performance
Feedback
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Relevance
 Relevant Information has two
characteristics:
 It occurs in the future
 It differs among the alternative courses
of action
 Relevant Costs – expected future
costs
 Relevant Revenues – expected future
revenues
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Types of Relevent cost
Types of Relevant Costs
Types of Non-Relevant Costs
Future Cash Flows
Sunk Cost
Cash expense that will be incurred in the future as a
result of a decision is a relevant cost.
Sunk cost is expenditure which has already been
incurred in the past. Sunk cost is irrelevant because it
does not affect the future cash flows of a business.
Avoidable Costs
Committed Costs
Only those costs are relevant to a decision that can be
avoided if the decision is not implemented.
Future costs that cannot be avoided are not relevant
because they will be incurred irrespective of the
business decision bieng considered.
Opportunity Costs
Non-Cash Expenses
Cash inflow that will be sacrificed as a result of a
particular management decision is a relevant cost.
Non-cash expenses such as depreciation are not
relevant because they do not affect the cash flows of a
business.
Incremental Cost
General Overheads
Where different alternatives are being considered,
relevant cost is the incremental or differential cost
between the various alternatives being considered.
General and administrative overheads which are not
affected by the decisions under consideration should be
ignored.
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Identifying Relevant Costs
Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs. Avoidable
costs are relevant costs.
Unavoidable costs are never relevant and
include:
 Sunk costs.
 Future costs that do not differ between the
alternatives.
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Identifying Relevant Costs
 gather all costs associated with the
alternatives
 eliminate all sunk costs
 Eliminate all future costs that don’t
differ between alternatives
 left are the avoidable costs
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Irrelevance
 Historical costs are past costs that
are irrelevant to decision making
 Also called Sunk Costs- cost that has
already been incurred and that cannot be
avoided regardless of what a manager
decides to do
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Types of Information
 Quantitative factors are outcomes
that can be measured in numerical
terms
 Qualitative factors are outcomes that
are difficult to measure accurately in
numerical terms, such as satisfaction
 Are just as important as quantitative
factors even though they are difficult to
measure
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Terminology
 Incremental Cost – the additional
total cost incurred for an activity
 Differential Cost – the difference in
total cost between two alternatives
 Incremental Revenue – the additional
total revenue from an activity
 Differential Revenue – the difference
in total revenue between two
alternatives
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Relevent cost
of material
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Relevent
cost of
labour
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Types of Decisions
One-Time-Only Special Orders
Insourcing vs. Outsourcing
Make or Buy
Product-Mix
Customer Profitability
Branch / Segment: Adding or
Discontinuing
 Equipment Replacement






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One-Time-Only Special Orders
 Accepting or rejecting special orders
when there is idle production capacity
and the special orders have no longrun implications
 Decision Rule: does the special order
generate additional operating
income?
 Yes – accept
 No – reject
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One-Time-Only Special Orders
 Compares relevant revenues and
relevant costs to determine
profitability
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Special Orders
 Acki Company receives a one-time order that
is not considered part of its normal ongoing
business.
 Acki Company only produces one type of
silver key chain with a unit variable cost of
TL 16. Normal selling price is TL 40 per unit.
 A company in KKTC offers to purchase 3,000
units for TL 20 per unit.
 Annual capacity is 10,000 units, and annual
fixed costs total TL78,000, but Acki company
is currently producing and selling only 5,000
units.
Should Acki accept the offer?
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Special Orders
If Acki accepts the offer, net income will
increase by TL 12.000.
Increase in revenue (3,000 × TL20)
Increase in costs (3,000 × TL16 variable cost)
Increase in net income
TL60.000
48.000
TL12.000
Using the incremental approach:
Special order contribution margin = TL20 – TL 16 = TL 4
Change in income = TL 4 × 3,000 units = TL 12.000.
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Potential Problems with
Relevant-Cost Analysis
 Avoid incorrect general assumptions
about information, especially:
 “All variable costs are relevant and all
fixed costs are irrelevant”
 There are notable exceptions for both
costs
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Potential Problems with
Relevant-Cost Analysis
 Problems with using unit-cost data:
 Including irrelevant costs in error
 Using the same unit-cost with different
output levels
 Fixed costs per unit change with different
levels of output
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Qualitative Factors
 Nonquantitative factors may be
extremely important in an evaluation
process, yet do not show up directly
in calculations:




Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations – distance from
plant, etc.
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